Editor's Note: Against the backdrop of AI giants continuing to boost the U.S. stock market index and the ongoing increase in market concentration, Ray Dalio re-discusses a classic question in his latest note: When a revolutionary technology is changing the world, how should investors allocate their assets?
Dalio's key reminder is that technological progress itself does not necessarily mean that the relevant stocks are equally attractive. Throughout history, major technological cycles have often experienced excitement, overcrowding, volatility, and shakeouts, and even long-term successful companies like Microsoft and Apple have experienced significant pullbacks during these cycles. Today's AI industry is also facing multiple uncertainties such as overinvestment, intensified competition, geopolitical issues, tax policies, anti-AI sentiment, and the disruption from the next generation of technologies.
The most important point of the article is not to judge whether AI will change the world, but to discuss how investors should deal with the "highly concentrated" market structure. Dalio believes that as a few tech companies occupy an increasingly high weight in the index, investors need to be vigilant about whether they unintentionally hold a highly correlated, high-risk concentrated exposure. Instead of continuing to chase a few leaders, the truly more robust approach is to build a diversified portfolio consisting of high-quality, low-correlated assets and adjust the volatility level based on their risk tolerance.
In his view, knowing what you don't know is as important as thinking you know something. Faced with the current market environment driven by AI, characterized by high valuations and concentrated risks, investors should not directly translate their excitement about new technologies into a concentrated allocation to a few AI stocks. Diversification is the "investment holy grail" in Dalio's eyes to navigate through this technological cycle.
Below is the original text:
This note discusses: how to participate in the investment game under the current environment.
Imagine that you are playing a game like bridge, poker, backgammon, or chess, it's your turn to move, and you have a computer next to you that can assess the situation with you and advise on the next move. To me, the investing game is like this. Whether or not you have a computer to assist you, I believe you should:
Based on the current state of the chessboard, ask yourself what your next move should be. In other words, you need to act based on the existing characteristics of the market and the various forces influencing the market.
I have been involved in playing this game for a long time. At this stage, my goal is to convey how I would play this game; furthermore, I also aim to create a platform where everyone can explore the investment game in their desired way, learn, backtest how they would have performed in the past, and truly excel at it. I believe that there are correct and incorrect ways to handle the cards you have been dealt. Therefore, when faced with a scenario like XYZ, you should ask yourself, "In this situation, how should I bet?" and be able to provide a good answer.
Now, I want to share with you my view of the current market characteristics, what I believe should be done, and what I am actually doing.
How to Respond to the Current Environment
What are the most crucial environmental factors at play right now? How should one bet in light of these factors?
In my view, and perhaps in the view of many, the current market environment is characterized by an industry primarily driven by significant new technologies, particularly AI, where only a few companies dominate market trends. These companies hold a high proportion of the total market capitalization and are exerting a significant influence on the market and economy. All such periods share a common trait: a great deal of excitement, uncertainty, and volatility centered around the new technology sector, which then ripples through the global stock market. Therefore, the volatility and uncertainty surrounding this sector are paramount.
Additionally, there is uncertainty related to other major drivers. I refer to these drivers as the "Five Forces": 1) What is happening with debt and currency; 2) What is happening with political and social issues that may significantly impact taxation and other politically driven market factors; 3) How do geopolitical factors affect the market, e.g., through war; 4) What natural forces are at play; 5) What new technologies are emerging. I feed these circumstances into my investment system to guide its decision-making on how to bet in these environments, while I also independently contemplate where to place my bets.
When contemplating how to bet in these environments, the most crucial question is: What kind of choice do you actually want to make? a) Favoring new technologies over broad-based stock indices such as the S&P 500, i.e., overweighting this new sector or overallocating to what you believe are the best companies in this industry; b) Keeping your exposure roughly around index weightings; or c) Diversifying out of this concentration?
Almost everyone wants to find the best investment and is willing to work hard for it. Currently, there seems to be a new technology that is transforming almost everything. However, history has shown that at this stage of the cycle, most people fail because they have placed a large proportion of their chips on the stocks of a few leading technology companies. There is a logically consistent reason behind this trend, and it has always played out this way in the past. Although this time AI technology is indeed unique, there have been many equally "unique" technologies in history that can serve as analogies and references. People should study these cases; if they choose to ignore them, they must be able to explain convincingly why this time is different.
The Risk Is Undeniably High
All major new technologies in the past have unfolded in a similar way due to the same logical reasons. High risk and immense uncertainty are inherent features of these new technology companies. Looking back at the performance of such companies in similar environments in history, we find that even the best revolutionary new technology companies that have thrived in the long term, such as Microsoft and Apple, have also faced severe setbacks at similar stages of development. Moreover, at the inception of these new technology companies, rather than in hindsight, it is not easy for people to judge which companies will succeed and which will fail, as seen with IBM. If you observe all these cases, you will see that significant new technology companies naturally have a highly uncertain future.
For instance, they either overinvest or underinvest. The reason is that if they do not invest enough to win the competition, they will surely lose; however, they cannot precisely know what the future holds to judge if they have overinvested. The cost of either overinvestment or underinvestment is very high.
Furthermore, they cannot foresee all changes accurately, including exogenous changes such as monetary tightening, war, significant tax changes, which can affect them. Therefore, they all go through intense upward and downward cycles: initially exciting investors, then scaring them off, washing out the weak-handed investors, and ultimately leading to market exaggerations. Furthermore, just as these new technologies and companies have disrupted their predecessors, most of them will also be disrupted by newer technologies and companies in ways we cannot foresee in advance. Therefore, we should also consider whether the same risks will occur with the current new technologies and tech companies. The impact of quantum computing is one of the known known risks we face. But what about the risks that have not yet been imagined?
What about the risks posed by competitors? For example, China is producing and disseminating AI technology, and Chinese policymakers have a fundamentally different view of the economy and AI. We are in the midst of a new technology war, with world leaders believing they must win this war. Their understanding of AI and its impact on the economy and people's well-being will drive them to provide this technology for free or at a low cost because it has tremendous productivity gains and can overall elevate living standards. In their view, the profits are less important than the overall benefits that many people using these new technologies would bring. I believe they will compete in the international market as they have in automobiles, solar panels, batteries, and many other products.
The current environment, similar to many historical examples that have provided valuable lessons, reminds me of how the UK defeated the Netherlands in shipbuilding and other key industries at the end of the Dutch Empire and the beginning of the British Empire. Furthermore, there is a geopolitical conflict around Taiwan that should at least make us consider one possibility: as a tool of geopolitical warfare, China may prevent chips from flowing out of Taiwan. AI stocks also face other risks, such as the risk of wealth taxes and other tax increases that may force a large sell-off by holders of significant wealth in these stocks; and the risk of rising anti-AI sentiment, which could restrict the space for companies to advance technological development.
I could list more worrisome things for you, but I could just as easily list an equally long string of enormous opportunities that AI will create, and which I am inclined to bet on. I am not saying how these risks will necessarily play out, or that one should not bet on AI companies. I am simply saying that there is a significant amount of concentration risk in the market, which is undeniable, and that people should be aware of how to deal with such an environment. Based on my research into all similar cases and the logical reasons behind them, I am convinced that the risks are high, and the best way to deal with this environment is:
Embrace Diversification
You may know that my mantra is "diversification." My "investment holy grail" is to strive to hold 15 high-quality, uncorrelated, and risk-balanced investments. In other words:
An investment portfolio composed of high-quality bets that is well-diversified will outperform a single concentrated bet. Its risk-return ratio is higher, and it can achieve better returns at the same risk level through engineering. The more risk is concentrated in one area of the market, the more one should diversify—especially when the market is being driven by revolutionary new technology, as this technology itself introduces significant uncertainty.
This is not a viewpoint but a mathematical certainty. For example, if I take an investment with a risk-return ratio of 0.3, assuming a return of 6% and a standard deviation of 18%, which is typically what people assume for stocks, if I hold 5, 10, or 15 uncorrelated investments, I can achieve the same 6% return but with standard deviation risks reduced to 8%, 6%, and 5%, respectively. Therefore, by holding 15 high-quality and uncorrelated investments, my risk-return ratio would increase by 4.3 times, from 0.3 to 1.29. If desired, you can leverage on top of this to achieve much higher returns at the same risk level. This is a fact.
I have strong confidence in this. It comes from my backtesting, the actual returns I have delivered over my over 50-year investment career, and the logical probabilities therein: excellent diversification of bets, adjusted to the volatility one is willing to tolerate, will in the long run produce far better returns than most investors' preference for concentrated bets. Specifically, through good diversification, one can achieve a better risk-return ratio than any concentrated bet; adjusting it to the risk level one is willing to take on can deliver higher returns at the target risk level than any other process.
Since I am passing along this approach, it is now my "not-so-secret" path to investment success. Nevertheless, I rarely encounter investors who think about investment strategy in this way. That is to say, I rarely meet people who truly think from a portfolio construction perspective, considering how a well-structured, diversified portfolio would perform differently compared to concentrated holdings in a great new transformative industry. Most people are just contemplating whether these stocks and this industry will perform well and how to bet on them. Those who think about portfolio construction and those who do not will ultimately have vastly different performance outcomes. Therefore, I will elaborate more fully on my thoughts on how to do this well at another time.
For all these reasons, in the current environment, thinking about how to play the hand you have been dealt should make one ask oneself: How much concentration should I actually have, and then diversify.
The Return Outlook Appears Very Low
The high risk is indisputable. Next, I am going to present a possibly incorrect view: the expected future return looks very low. My judgment on the expected future return comes from valuation-related analysis work and my Bubble Indicator readings: the real return on stocks over the next 5 to 10 years looks to be around -5% to -10%, although these numbers have quite a bit of uncertainty. In my view, these stocks are long-duration assets, high risk because people find it difficult to reliably see far into the future; at the same time, they appear pricey, and the holder base is not stable.
A Question from My Research Team on This Topic
At a recent meeting, a member of my research team asked me: Why do you think the market is misallocated in the way it is today? How do you know that the lack of diversification in today's market is not for good reasons? For example, some investors believe the expected return on AI stocks will be very high; or, when an industry occupies such a large proportion of total market cap, this index concentration would naturally occur; or, when an industry is highly enthusiastic, many investors will buy these stocks without doing smart and reliable calculations on what future earnings will look like and how these earnings should be reflected in stock prices.
My Response
Price appreciation has various reasons, and not all of these reasons are good. Some investors think about the price and drive it up because they believe the price is still attractive relative to fundamentals; some investors hold these stocks long term because they recognize it as a great new technology and view the price increase as confirmation that they are good stocks; and some investors have index exposure, which passively gives them a large weight in these stocks. In my view, you can get caught up in these issues to decide what you want to do; or you can realize that you do not need to get caught up in this issue because you simply do not have enough information to confidently bet. You can entirely say, "I don't know enough, not enough to bet." And then not bet.
What gets people into trouble is thinking that they must form an opinion and believing that their opinion is valuable; but the more likely scenario is that they can't form a sufficiently reliable, bet-worthy opinion.
Footnote: To be clear, I am not suggesting avoiding bets. Besides, you can't avoid bets because you have to put your money into some kind of investment or cash. Most people think cash is the lowest-risk investment, but in the long run, it is almost certainly the worst. What I suggest is that even if you don't have a tactical view on which market is good or bad, know how to diversify your bets well. The way to do this is to have a well-balanced strategic asset allocation portfolio and hold it when you don't have enough confidence in a tactical bet. But that's a topic for another time.
Therefore, I believe: Knowing what you don't know and deciding when not to bet, and knowing what you know and deciding when to bet, are equally important.
In simpler terms, I believe in the following principle: Since it is usually hard to know enough to prove that concentrated betting is reasonable, the best way is to only hold a diversified investment portfolio composed of bets you are most confident in and unrelated to each other, and engineer this combination to adjust to the risk level you are willing to take. That is my "Investment Holy Grail."
At this moment, considering the current environment, I don't believe anyone is clear enough about what will happen next in this technology-driven market to place a huge and concentrated bet. In my view, avoiding concentration and maintaining diversification is the best way to deal with this "unknown." I know this is contrary to the theory you might read in textbooks. Textbooks fundamentally say that the market is efficient, so you should "trust the market."
In summary, the current market is abnormally concentrated and revolves around a revolutionary new technology. This fact should remind us: Do not confuse your excitement about new technology with whether the tech stocks themselves are attractive; nor should you forsake caution by holding a highly risky, highly correlated concentrated bet. Especially when we can achieve equally attractive returns with much less risk through smart diversification, we should not do so.
Appendix: I will not share my specific holdings or tactical views with you because I don't want to be your investment advisor. But I will soon share with you some key perspectives behind these views, including my bubble indicators reading and the logic behind them.
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